FIN 320F Foundations of Finance 1.6 Federal Reserve – Solutions QE3: What is quantitative easing? And will it help the economy? By Brad Plumer, Updated: September 13, 2012 What is quantitative easing? Short answer: It’s an unconventional monetary tool used by central banks to stimulate the economy. Answer that might make sense: Normally, when there’s a recession or the economy is limping along, the Federal Reserve will reduce short-term interest rates in order to spur more lending and spending. But right now, the Fed has cut interest rates as far as they can go and the economy is still struggling. This is known as the “zero bound.” The Fed can’t go any lower. So, instead, the central bank can try quantitative easing. Since the Federal Reserve can just create dollars out of thin air, it can buy up assets like long-term Treasuries or mortgage-backed securities from commercial banks and other institutions. This pumps money into the U.S. economy and reduces long-term interest rates further. When long-term interest rates go down, investors have more incentive to spend their money now. In theory. Hasn’t the Fed already tried quantitative easing? Yes. Twice in fact. In late November 2008, after the financial crisis hit, the Fed started buying up mortgage- backed securities and Treasury bills in order to boost the economy. By June of 2010, the bank had bought about $2.1 trillion worth of assets. At that point, the Fed halted its actions, figuring that it had done enough. But when the economy started weakening in August 2010, Bernanke resumed the program, buying up another $600 billion in assets in order to maintain the Fed’s balance sheet. (Remember, the bank is holding a bunch of debt that slowly matures, so if the Fed does nothing, all that money it had injected into the economy will eventually get sucked back out again.) This was known as “QE2.” Did QE1 and QE2 actually boost the U.S. economy? Academics have been churning out plenty of research on this question. The first round of quantitative easing appeared to be effective in preventing the economy from sinking into a giant depression. Economists say this was because everyone saw the Fed would do whatever it took to avoid deflation. It was essentially a giant confidence boost. The economy stopped sliding and inflation slowly rose. But the effects seemed to dwindle as the years went by. Experts are much more divided on how much QE2 has helped. In theory, quantitative easing should work in two ways. First, it injects more cash into banks, allowing them to lend more. And second, it lowers interest rates — if the Fed buys up a bunch of debt securities, it should make it cheaper to borrow money to buy a house. In practice, interest rates do drop. But it’s hard to figure out whether this translates into a boost in the actual economy. Low mortgage rates can only do so much if banks remain tightfisted about lending. UPDATE: QE3 has been announced! So what ...